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Economy/ China Economy

Shanghai, Guangdong debt pilot programmes aim to reduce China’s hidden local government liabilities

  • Shanghai and Guangdong will focus on better self-regulation to curb hidden debt risks, while also looking to convert some of the debt into regonisable debt
  • Debt issued by local government financing vehicles (LGFVs) have long been a major concern for the central government
Debt issued by local government financing vehicles (LGFVs) in China is often used to fund infrastructure projects. Photo: Xinhua

Two of China’s wealthiest regions have set up pilot programmes aimed at eliminating so-called hidden local government debt, but questions have been raised over how much can be done amid rising risks that Beijing may be forced to step in and bail out authorities.

Last month, the financial city of Shanghai and the southern manufacturing powerhouse province of Guangdong signalled local governments are keen to tackle their mounting debt by launching trials to clean up off-budget lending.

Debt issued by local government financing vehicles (LGFVs), which are local authorities’ preferred financing platforms, have long been a major concern for the central government.

LGFV debt, which is made up of bank loans and bonds, could pose a contagion risk to the country’s state-dominated banking system as many lenders have significant exposure to local government debt but public data on the size of the debt owed is not available.

China’s Ministry of Finance has tried to improve the transparency of LGFV debt, which is typically invested in infrastructure projects, but analysts believe there may only be so much the central government is willing to do to declare its actual level of debt.

“There is always a deliberate ambiguity involved, on both sides,” said Logan Wright, director at Rhodium Group, who leads the firm‘s research on China.

Beijing wants local governments to manage their own financial problems and reduce the size of their debt rather than rely on the central government to offer a guarantee, said Wright.

But at the same time, authorities do not want to disclose large debt burdens because it may put limits on the refinancing chances of their LGFVs and the companies they control.

Both sides have incentives to limit transparency into the size of the overall local government debt burden, and to reduce the level of debt that is publicly disclosed, or even disclosed by localities to Beijing Logan Wright

“As a result, both sides have incentives to limit transparency into the size of the overall local government debt burden, and to reduce the level of debt that is publicly disclosed, or even disclosed by localities to Beijing,” added Wright.

According to estimates by the National Institution for Finance and Development (NIFD), a government-affiliated think tank, Shanghai and Guangdong had the lowest leverage ratio in 2020 when taking into account both their explicit arefnd implicit debt as well as their overall fiscal condition.

Shanghai has the lowest leverage ratio of all 31 of China’s provincial-level jurisdictions at 59 per cent, according to estimates by the NFID, with Guangdong at 72 per cent. Tianjin had the highest leverage ratio of 220 per cent in 2020.

For now, details included within the pilot schemes and announcements made by officials in Shanghai and Guangdong indicate that the two local governments will focus on better self-regulation to curb hidden debt risks while also looking to convert some of the debt into regonisable debt.

The Guangdong government has vowed to review its borrowing and provide “timely feedback on the existence of hidden debt problems, reminding financial institutions to prevent financial risks”, according to a report by local government-owned Guangzhou Daily on Monday.

In a report published by the Shanghai Supervision Bureau of the Ministry of Finance in July, 11 districts have been warned of hidden debt risks. Going forward, authorities will step up inspections of key projects by district officials and strengthen the guidance of debt management while also providing “timely intervention” to resolve hidden debt, the report said.

“The fact that new efforts and programmes are still required to rein in local government debts is a testament to how hard this problem has been to fix,” said Nicholas Borst, director of China research at Seafarer Capital Partners.

Sun Binbin, chief fixed-income analyst at Tianfeng Securities, said in a report at the end of October that the hidden debt pilot schemes in Guangdong and Shanghai demonstrate how policy could be implemented, but a total elimination of hidden debt is unlikely to be widely accepted by other local governments.

The regional economic and financial strength is very strong [in Shanghai and Guangdong], and the debt level is low. In other regions, the current strategy is buying more time to adjust the debt maturity structure and reduce borrowing costs Sun Binbin

“The regional economic and financial strength is very strong [in Shanghai and Guangdong], and the debt level is low. In other regions, the current strategy is buying more time to adjust the debt maturity structure and reduce borrowing costs,” Sun said.

Dinny McMahon, global fellow with the Woodrow Wilson International Centre for Scholars, said that local governments may also have to consider selling their assets, including land, mining resources and stakes in companies, to pay off their debts.

“I don‘t think there is a clear strategy in dealing with [local government debt] at the moment,” said McMahon in a panel discussion hosted by the University of Chicago on China’s debt problems on Tuesday.

“The best articulation of what the fallout is going to be is a sharing of the burden – central government mobilising its resources and banks having to take it on the chin.”

China is also in the midst of reducing leverage in the real estate market, which is linked to local government revenue, and a significant correction in the property sector could spell trouble for the financially weak regions that heavily rely on land sales as income.

In such a scenario, Chen Zhiwu, a finance professor at the University of Hong Kong, believes China may have to resort to expanding its monetary policy by printing more money to resolve the local government debt crisis.

“Given the political institutional infrastructure in China, ultimately this is the way to go,” Chen said during the University of Chicago panel this week.

A special purpose bond programme set up by the Ministry of Finance in 2015 was aimed at replacing LGFV debt, thereby increasing the transparency of local government borrowings, but it has not been wholly successful.

The quota, which was around 3.65 trillion yuan (US$570 billion) in 2021 having been set at 3.75 trillion the previous year, was ultimately deemed too small to cover hefty infrastructure borrowing, which is part of China’s fixed asset investment.

Last year, China’s total fixed-asset investment rose to 51.9 trillion yuan (US$8.1 trillion), an increase of 2.9 per cent compared to 2019.

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In 2019, the Ministry of Finance began to roll out a pilot programme to replace hidden-debt for counties and districts, in particular, focusing on regions with weaker economies that have high repayment pressure.

A number of LGFVs have already defaulted on interest payments and principals and some have been shut out of the capital markets entirely because of their poor credit record.

According to figures released by China’s Ministry of Finance in August, 612.8 billion yuan from a bond quota of 609.5 billion yuan had been issued by the end of July.

Laura Li, senior director at S&P Global Rating, believes the quota could help alleviate the refinancing pressure faced by weaker LGFVs, particularly those who cannot refinance their debt in the capital markets at reasonable levels, although it will not be sufficient to cover all the debt payments.

Because when the local government debt worsens, it will inevitably trigger a banking crisis or even systemic risk. In the end, the central government will definitely intervene, but the cost will be extremely high NFID

“But such quotas may still be subject to the overall debt limit of their government owners. A vast majority of LGFVs still have to rely on capital market access to refinance their domestic bond maturities,” Li said.

The NFID report suggested that the central government could selectively swap some of the local government debt with sovereign debt and coordinate with banks to restructure loans.

But there are limitations as to what local governments, such as those in the central and western regions, can do on their own to resolve their debt problems due to poor economic prospects and high debt levels, the NFID said.

“Because when the local government debt worsens, it will inevitably trigger a banking crisis or even systemic risk. In the end, the central government will definitely intervene, but the cost will be extremely high,” said the NFID report.